Reverse Mergers

Reverse Mergers - Going Public by Reverse, a Continuing Legal Education course by David Lubin

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Getting There in Reverse An Alternative to the IPO by David Lubin

As we have seen in recent months, even after spending valuable time and money preparing your company for an IPO, market conditions ultimately dictate whether you will even make it out of the starting gate. A slow and dry IPO market, accounting scandals and investors still feeling the pain from the recent dot-com and tech debacle do not paint a rosy future for such actions. An alternative to the tortuous IPO route is the process of becoming a public company through a reverse merger transaction. Merging an operating company into a public shell company can accomplish most of the objectives driving the decision to go public at a significantly lower cost and within a more expedient time frame. Reversing a private company into a public company was the route taken by several companies such as Turner Broadcasting and Occidental Petroleum.

Like almost everything in life, there are positive and negative attributes to a reverse merger transaction. However, with meticulous preparation, such a transaction might be the proper route for many companies-especially for an operating company with growth potential but not a sufficient amount of revenues to attract an underwriter.

The Reverse Merger

In a typical reverse merger transaction, a private company with operations or a significant business plan is merged into a private shell company. The owners of the private company receive a controlling position in the public company and continue their business through the public entity. While the existing stockholders of the public company are diluted as a result of the issuance of a controlling block of stock, the shell company has been transformed from a dormant entity into an operating company with growth potential. As a result of the merger, the company becomes public without the necessity of filing a registration statement (which is generally rigorously reviewed by the SEC). The reverse merger can be accomplished within as little as 30 days.

Reasons to go Public

A public company is able to offer liquidity to its stockholders, employees and consultants, as well as utilize its stock as acquisition currency, as means of motivating management through stock options and other forms of stock performance based compensation and as consideration for an acquisition in lieu of, or in addition to, cash, makes the stock of a public company much more attractive than the illiquid stock of a private company. Liquidity is obtained as a result of both an IPO and a reverse merger, but securities law imposes restrictions on the ability of company insiders to sell their shares.

Another factor in the decision to go public is to raise the profile and credibility of the company in the eyes of its business partners, suppliers and future financing sources. Although a well-orchestrated IPO can create a certain "buzz" about the company, a carefully planned investor relations campaign can accomplish the same result. It is the performance of the company shortly thereafter which is necessary in either case to sustain the market value of the company.

It is difficult for a private company to obtain additional cash infusions. Certain financing sources will only make equity investments or accept debt instruments from public companies. Moreover, being public means that audited financial statements are readily available, making banks and other traditional financing sources more inclined to lend.

An IPO is a securities offering to the public for the purpose of raising money for the company. A reverse merger is a transaction where the private company becomes public and no cash inflow is made into the company (unless the public company has the cash prior to the transaction). However, since it is generally easier to raise money through a public entity, it is prudent to commence an offering of the company after the merger is completed.

Unique Concerns of the Reverse

Although the reverse merger can be accomplished cheaper and quicker than an IPO, extensive due diligence must be conducted on the shell company and its principals. The transaction is structured as a merger so that the public vehicle remains the surviving entity. Accordingly, all obligations of the shell company, whether known or unknown, survive the merger. A significant liability, such as outstanding tax obligations or environmental liabilities, can adversely impact the operations of the company on a going-forward basis. Personal indemnification agreements from the principals of the shell and hold-back or escrow provisions can minimize the risk.

The status of the company subsequent to the transaction is another area of concern unique to reverse mergers. Prior to the transaction, the shell company may not be listed on a stock exchange. Since one of the objectives of the merger is to make the private company listed, the qualification requirements of the desired exchange will need to be analyzed to determine if the transaction satisfies the objective.

It is also important to verify that all the outstanding shares were properly issued. Not only must the company have the proper authorization to issue the shares, but the offer and sale of the shares to the stockholders must have been done in compliance with federal and state securities laws.

Conclusion

While a reverse merger alone does not initially create new capital for the company, it accomplishes many of the other motivating factors of an IPO with a significant reduction in time and money. Management, especially those of small companies with accelerated growth mode, should consider the reverse merger as a viable alternative.

Published in Empire Magazine May 2002